The default option in the new pension system will dramatically enhance gains. Over a long-term your investment will have a very high degree of safety and will get you returns to beat the inflation
05-Feb-2007 •Dhirendra Kumar
There have been some news reports recently that the default option in the new pension system will be for contributions to flow to equity for younger people and that the asset allocation will tilt towards debt as the contributor gets older. Many of those who have written about this seem to be looking more from the stock market's point of view than from the investors'. The angle seems to be that now more money will flow into the markets and so here's yet another reason for the markets should go up next week. Short-term cheer-leading of the markets aside, if this actually happens it will be a wonderful thing and will mean that a large number of people will be passively pushed into the best possible pattern of investing. However, those of us who aren't part of the pension system or invest more than what the pension system decrees do not actually have to be left out-it is an exceedingly simple matter to invest in this pattern by oneself.
For those who haven't been following the news on the new pension system, here's what all this means. In the old pension system, all money is invested in government securities or in other instruments which are backed by the government and thus carry a very low risk of default. In the new system, there is an option of a part of your pension money to be invested in equities too. There's nothing new in this. What is news is that the default option for pension contributions will be one where the equity part will be as high as XX per cent when the employee is young. As he or she gets older, this percentage will keep coming down and will eventually become zero or almost zero close to retirement. The significant part here is that this is the 'default' option, that is, if the employee does not indicate a preference, then this is the option into which the money will go.
The resulting investment pattern will mean that a steady amount of money will be invested in equities every month and that this amount will rise as a person's income rises. The amount that goes into equities does not go up and down with the stock market, as it generally does when one is making investment decisions on the fly. This means that one gets the benefit of cost-averaging and automatically ends up buying more shares at a lower price and less at a higher price. In the long run, this dramatically enhances the gains one can make from the same investment. Over a long-term (anything over ten years), such an investment strategy has a very high degree of safety and gets you the kind of returns that are really needed to keep your nest egg safe from inflation.
Remember that in the long run, the poor returns over the inflation rate that are offered by 'safe' investments are really a far bigger threat to your savings. It's good that this is going to be the default option for pensions because it is by far the best option.
And, as I said right in the beginning, there's no reason why only your pension contributions should enjoy this method of investing. The combination of bit-by-bit investing and a steady rebalancing of one's debt-to-equity ratio as one gets older can be done manually, as it were, or is available as a feature from many mutual funds. All one needs to contribute is some cool-headed thinking and the money, of course.